Department of Management Science & Engineering

Number 8/Spring 2001

Investment Science Newsletter

By Professor David G. Luenberger
luen@stanford.edu

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CONTENTS

FORUM

THE WEBSITE

STANFORD PROJECTS COURSE

SHORT COURSE NEWS

OPTIONS DIRECTIONS

It seems surprising that this is the eighth newsletter for the Investment Science program at Stanford.  That means that newsletters have been published for over four years now.  I know that some of you look forward to receiving the newsletter and keeping up with our progress.  It is always good to hear from you.

It is traditional that the newsletter contains small items of news related to our program and a short semi-technical article related to investment science for industry.  In this issue, I will present a brief survey of what I believe are the trends in real options theory and application.  "Real options" is still quite popular, but I have mixed feelings about the term.  On the one hand, it is somewhat of a misnomer (as I will discuss in the article) and it is a bit limiting since many important decisions are, strictly speaking, not options.  On the other hand, the term "real options" signals that the methods used are modern; they are related to the innovations of finance that sparked the revolution in derivative securities, and they are more robust than traditional discounted cash flow analysis.  Hence, in that broad view, I like the term "real options" and its continued popularity perhaps means that there is growing interest in using advanced methods.  Certainly from an academic viewpoint, we are expanding our understanding of valuation issues and learning to address ever more important and interesting issues.


The Website

The Investment Science website at www.investmentscience.com  has been recently revised.  You will find copies of past issues of this Newsletter at the site, as well as additional information about investment science projects and software tools.  Your comments on the site are welcome.


Stanford Projects Course

As part of the Stanford academic program in Investment Science, Robert Luenberger teaches a course for graduate students titled "Investment Practice".   In this course, students who have studied the theory of investment science work on real projects for real companies.  In some cases these projects have been originated by past participants of the Investment Science for Industry course (that is, from people like you).  There is no cost to the sponsoring  company for such a project, but the project must fit into a one-quarter time frame.  This year the course begins at the end of March.  If you have a potential project, contact Rob at Onward, Inc. 650-943-1703 or rob@onwardinc.com.


Short Course News

Investment Science for Industry was given at Stanford last September.  Our example projects are expanding and we have a new overview of the role of options in project design.  The course continues to provide us with inspiration in our research and graduate teaching.

The course will next be given this April 26-27.  Past participants have referred colleagues to the course, and this is very much appreciated.  I hope you will consider presenting the idea of the course to your colleagues.  You may refer them to the course through the web site http://www.stanford.edu/~luen/investment  or to the www.investmentscience.com  website mentioned above.


Options Directions

Options theory as applied to business problems has evolved substantially in the past few years.  Many more people are aware that there is something powerful embodied in the real options approach and that it has great benefits compared to simple discounted cash flow analysis.  However, we have always emphasized that the underlying concepts are more general than their use in real options, and we have used the term Investment Science as a term that encompasses all of modern finance, without the limitations of real options.

In this short discussion, we will sketch a few layers of options theory, with emphasis on how the theory relates to business issues and how it is becoming more general.

1. Stock Options. The Black and Scholes analysis of stock options in 1972 was a breakthrough in modern finance.  The approach was truly revolutionary, for it showed how the value of an option on a stock could be related to the value of the stock itself.  Basically, the theory related the dynamic behavior of the option to the dynamic behavior of the stock.  A shorthand way to explain the theory is that since the option value in the future will depend, day by day, on the stock value, it must be possible to trace the relation backward in time to find the current option value. The stock is an underlying security, and its behavior contains all the uncertainty about the option.

2. Real Options.  A few years after the introduction of the Black-Scholes theory, researchers began to apply options theory to options on physical items, such as gold mines, oil fields, and so forth.  These were termed real options.  The associated traded commodity (e.g. gold or oil) served as the underlying security.  This approach was quite successful, except that the number of problems that fall into this category is limited.

3. Project Options.  Next, the theory was applied to general business projects, such as new-product development, marketing campaigns, supply chain operations, and so forth.  Many people did (and still do) attempt to apply the Black-Scholes theory directly to these situations.  However, this is incorrect.  Unlike stock options or even real options on physical commodities, there may be no pure underlying security associated with a project option, and hence the basic assumptions of the Black-Scholes method do not hold.  For example, some practitioners (mis)applied the Black-Scholes method to electricity pricing with disastrous results, since electricity is not storable.  At Stanford we have worked on project options for several years, and have developed the appropriate modification of the Black-Scholes approach, which recognizes that there is, at best, only partially related underlying securities associated with business projects.   We now have a methodology that is both rigorous and well suited to application, and we have worked with several companies on specific projects.  In the two-day course, we include examples for which there is not a strict underlying security.

4. Interactive Business Model Options.  The next level deals with issues associated with business model alternatives.  Although some business model decisions can be regarded as project options, many such decisions involve relations with other companies or depend on what other companies do.  For example, a license agreement looks like a project option if considered from the viewpoint of a single party, but is an interactive option if both parties are considered simultaneously.  Likewise, the design of an option between supplier and user that accounts for the impact on both parties is an interactive business model option.  Another example is the design of a capital expansion strategy in a capital-intensive industry where cycles of expansion and contraction are typical (as discussed in Newsletter 7).  Our Stanford program has begun research in such interactive business model options. The concepts of real options are helpful in these situations, but additional concepts are needed.  Fortunately, those additional concepts are available and easy to understand.  I believe that this level of work will have a profound influence on business, for the issues it addresses are fundamental to business success.

(There is yet another stage of option development, but it is on the distant horizon.)

I look forward to the continued evolution of this important and exciting field.  And I hope to work with some of you during this evolution.